Are Dividend Stocks Safer Than Government Bonds?

Central banks seem to think so, with South Korea and Japan branching out into equities

Here’s a news flash that’s a bit old, but staggering in its implications: Central banks — entities charged with providing quick access to a nation’s hard assets to back up its currency — are increasingly dabbling in stocks because bond yields are ridiculously low.

So are dividend stocks actually a lower-risk investment, on the whole, than bonds?

Some central bankers seem to think so, judging by their actions. After all, these are institutions that act out of capital preservation to back up their national currencies, not investment banks looking to make billions in profits through active trading.

Israel’s central bank started buying equities this year, investing 2 percent of its foreign exchange reserves in U.S. stocks. Eventually, it plans to raise this to 10 percent, or nearly $8 billion.

South Korea’s central bank’s share of stocks in its reserves grew to 5.4 percent last year from 3.1 percent in 2009 and the Czech Republic’s bank has increased its equities holdings to 10 percent of its foreign reserves over the past three years.

It’s pretty telling when “national reserves” are in fact investments in blue-chip stocks. According to previous reports, Israel took a stake in (what else!) Apple (NASDAQ:AAPL) as well as equity index trackers that presumably are heavy where the S&P 500 and the Dow Jones Industrial Average are weighted — mega-caps Exxon (NYSE:XOM), General Electric (NYSE:GE), IBM (NYSE:IBM) and AT&T (NYSE:T), for example.

Why the Risk of Stocks?

Before you panic and start worrying about conspiracy theories, note that the Federal Reserve’s charter forbids it from buying equities. So don’t fret about speculation by Ben Bernanke anytime soon.

But regardless, it’s a head-scratcher for many who read all the ugly headlines about sovereign debt these days. How can investors be so eager to lend to debt-riddled governments that rates are this low? And even if they are, why would stocks really be safer in these volatile times?

Well, the reality of the situation involves the multifaceted nature of investment risk and finances. Namely, that even when you choose to do nothing with your money it is at risk in some way … from inflation right now, in particular.

The low-risk, safe haven of highly rated sovereign debt has paradoxically made these kind of investments “risky” because they are almost guaranteed to be a money-losing bet. People have flocked to quality sovereign debt in such great numbers that the yields are significantly lower than inflation — so while Treasury notes may hold value better than money stuffed under the mattress, they still fail to fully preserve capital.

Consider that the lowest yield among S&P 500 sectors is about 1.6% for Healthcare Equipment & Services (calculated at the end of Q3). Other industries like Commercial & Professional Services (3.9%) and Household & Personal Products (3.2%) are significantly higher.

You can understand the appeal.

And what happens if the rate of inflation picks up significantly in the future? Those small shortfalls could become significant.

Of course, the downside risk is severely limited in Treasuries. If inflation picks up to some staggering number like 5% or more, blue-chip stocks could take a tumble and losses would be even steeper than the spread between a meager government bond and the rate of inflation.

It’s also worth noting that equities can come with some painful liquidity issues. Any trader who’s been forced to raise cash at a bad time knows the pain of being forced out of stock during a downtrend rather than waiting for the inevitable rebound. Imagine a central bank that needs liquidity, forced to sell its stocks into a falling market during the crash. It’s scary to think of a central bank facing a margin call, but it could be a reality if another crisis hits.

Still, the bottom line is that most investors are flocking to dividend stocks right now because the high demand for low-risk Treasuries mean you have to settle for a slow bleed in your nest egg thanks to inflation. Why settle for a loss when you can take responsible risks in stable blue-chips instead?

At a Glance

Even when you choose to do nothing with your money it is at risk in some way … from inflation right now, in particular. The low-risk, safe haven of highly rated sovereign debt has paradoxically made these kind of investments “risky” because they are almost guaranteed to be a money-losing bet.